Financial analysts » Market

Tracking Error

admin — Sun, 04 Jul 2010 08:35:50 +0000

Just as corporations have to deal with “forecasting error” in terms of the deviation of forecast exchange rates relative to the actual future rate, so investors have to deal with “tracking error” within their portfolios, which is the return of the portfolio relative to the investment benchmark index being used. Within this, there is “expected” and “realized” tracking error. Expected tracking error is as the name suggests determined before the fact — ex ante — whereas the realized tracking error is determined after the fact.
Determining the relevance of tracking error is also a function of comparing the portfolio’s hedging strategy with a random strategy, which creates hedge/don’t hedge signals with equal probability on a regular basis. Using polar benchmarks — i.e. 0% or 100% hedged — the equal probability of the outcome of the random strategy suggests that hedge deviations will be zero in half the cases and 100% in half the cases. However, with a partially hedged currency benchmark, the deviations will vary in direct proportion to the ratio of the benchmark. For instance, for a symmetrical or 50% hedged currency benchmark, the deviations will be 50% from each side of the benchmark.
From this, we can gather two things, firstly that the tracking error — or the deviation — is a function of the hedged ratio used for benchmarking and secondly that the tracking error for a partially hedged benchmark should be less than that for a polar benchmark. Indeed, generally, the tracking error for a symmetrical or 50% currency hedging benchmark should be around 70% of the tracking error using polar benchmarks. Expressed differently, the tracking error of a polar benchmark should be 1.41 (square root of 2) times higher than that of a 50% hedged benchmark. The advantage of a symmetrical or 50% currency hedged benchmark for a portfolio manager is that it reduces the tracking error of the portfolio and also enables them to participate in both bull and bear markets compared to the polar benchmark where the participation is limited to either/or.
Tracking error can be further reduced by a technique known as “matched hedging”, which increases or decreases the hedge ratio relative to the change in asset allocation. Historically, the act of asset allocation itself within fixed income portfolios has been a major and seemingly unavoidable factor in increasing a portfolio’s tracking error. Matched hedging can reduce though clearly not eliminate this.
Tracking error can also occur under passive currency management. This is because in order to implement a passive currency hedging programme a portfolio manager still has to adjust the amount of the currency hedge relative to the value of the underlying as it changes on a regular basis — i.e. once a month. In reality, many portfolio managers don’t bother to do this. As a result, the residual that is left over- or under-hedged contributes to the tracking error. In this, the portfolio manager has to balance the transaction costs of re-balancing the currency hedges against the negative effect on tracking error.

EMERGING MARKETS AND CURRENCY HEDGING

admin — Mon, 06 Jul 2009 08:37:42 +0000

It has been noted that emerging markets have different market properties to those of the developed markets. Here, it is important to sell these out and then in turn relate them to the considerations of passive and active currency risk management. First off, let us look at the major differences that appear present in emerging markets:
Liquidity risk — Emerging market currencies are less liquid than their developed counterparts. For instance, every day some USD300 billion goes through EUR–USD. This compares with around USD10 billion daily in the South African rand. Needless to say, this lower liquidity affects pricing and price action.
Convertibility risk — Even less than liquidity risk, convertibility risk is not a consideration for developed currency markets as all major currencies are freely floating and fully convertible. A number of emerging market currencies however are still not convertible on the capital account, and indeed a few are still not fully convertible on the current account.
Exchange controls — In line with this, several emerging market currencies still have varying degrees of exchange rate controls, which also distort exchange rate pricing and economic activity. Exchange controls create “black market” activity and paradoxically can lead to capital flight.
Emerging markets have structurally high levels of inflation — Stronger growth levels and economic inefficiencies are important reasons behind structurally high levels of inflation relative to developed markets. This in turn means that policy interest rates are in most cases substantially higher in emerging markets than in developed markets, resulting in high forward premiums.
Capital inflows however can depress market interest rates — The size of global capital flows relative to the size of local capital markets in most emerging markets can mean that the latter are swamped by a relatively small portfolio shift in assets either into the market or out of it. As a result, interest rate volatility is a lot higher.
Forward rate bias is lower in emerging markets — While forward exchange rates are poor predictors of future spot exchange rates in the developed markets, this is less so in many emerging markets. The exhaustive 2000 study by Bansal and Dahlquist tested the presence of forward rate bias and found emerging market currencies show significantly less correlation between current interest rate differentials and subsequent spot returns than those in the developed markets. That said, emerging market currencies tend to appreciate on a real basis and then collapse to adjust for the trade balance deterioration caused by that real exchange rate appreciation.
Implied emerging market volatility below developed market volatility is a buy signal —
Historically, lower levels of implied volatility in emerging market currencies than the corresponding developed market currencies has proven a good buy signal for the former. Intuitively, emerging market volatility should be higher, though there are periods when the sheer weight of capital inflows forces it artificially lower. Note that emerging market implied volatility is skewed in that it tends to fall only when the emerging market currency is strengthening, but always rises when the currency weakens.
Implied emerging market volatility is a very poor predictor of future exchange rates —
Looking at previous emerging market crises, the options market has usually got it “wrong” in the sense that such crises have never been priced in ahead of time by the options market. Thus, we can say that the options market is a poor predictor of future exchange rate levels in the emerging markets, though measured against historic volatility levels it may well be a much better indicator of relative value.
What we find in the emerging markets is that shifts in global capital flows have major domestic interest rate implications. For instance, high inflation and therefore interest rate differentials should, according to classical economic theory, suggest a depreciation of the local currency in proportion to that interest rate differential or forward premium. However, this may not occur due to heavy capital inflows, which swamp the domestic market’s ability to cope with these without economic distortion. As a result of this, the currency may experience significant nominal and real appreciation, in seeming violation of the international Fisher effect and covered interest rate parity. Real currency appreciation however leads to a real economic shock, and more specifically real trade and current account balance deterioration. Eventually, this has to be reversed and not too surprisingly through real currency depreciation. The longer and more powerful the real appreciation, the potentially more violent the subsequent depreciation. Emerging market currencies trade in these types of cycles, in line with the “speculative cycle” that we looked at earlier in the blog. As a result, we can tell from this that the forward rate bias is extreme for emerging market currencies on both sides of the forward. In line with this, some caution is needed in using the differential forward strategy in the emerging markets. Emerging market interest rate differentials would mean theoretically that an investor never hedged emerging market currency risk using the differential forward strategy, yet this is clearly not the appropriate strategy in some cases.
For similar reasons, the carry trade has provided significant alpha for active currency managers, both in the basic and in the optimized version. However, the distortion to interest and exchange rates that capital inflows provide in emerging markets means that a significantly higher degree of both care and discretion is needed in picking higher carry currencies to either invest in or hedge depending upon the reading of the risk appetite indicator.

Optimization of the Carry Trade

admin — Sun, 05 Jul 2009 08:36:58 +0000

The final strategy example that we will look at for active currency managers is that of optimizing the carry trade. We looked at the carry trade idea initially in earlier posts and will do so again in the nest few posts in the context of an appropriate strategy for currency speculators, when using a risk appetite indicator, for the purpose of gauging when are the best and worst times to buy higher carry currencies (and thus go short the lower carry currencies).
This combination of a risk appetite indicator and a basket of higher carry currencies can also be used for the purpose of currency hedging by an active currency manager who trades and hedges currency risk around their benchmark. For a currency speculator, the principle of the risk appetite/carry trade combination is that the basket of higher carry currencies should be bought when the risk appetite indicator is in either risk-seeking or risk-neutral mode and should be shorted when it is in risk-aversion mode. Similarly, the currency hedger could use this combination of indicators to go underweight the hedge relative to the benchmark in higher carry currencies when the risk appetite indicator is benign and overweight when the indicator moves into risk aversion. Such a strategy should reduce transaction costs relative to a passive currency management programme, while also reducing the portfolio’s overall risk and adding alpha.
Yet, we can fine tune this strategy still further using a portfolio optimizer to take into account the volatility and correlation of currencies in addition to their yield differentials alone. This should both in theory and practice produce better returns than the simple carry trade strategy. The carry trade can be an excellent strategy by itself for adding alpha, however it can also exhibit substantial volatility at times. A fine example of this was when the dollar–yen exchange rate fell by around 15% in the space of a few days in October 1998. By comparison, the optimized carry trade would in the case of the currency speculator represent the buying of higher carry currencies with low volatility and the selling of low carry currencies with high volatility. For the currency hedger, this would in turn mean going underweight the hedge relative to the benchmark on higher carry currencies with low volatility and overweight the hedge on lower carry currencies with higher volatility.
For both a portfolio manager who is looking to hedge currency risk and an active currency manager who can trade that currency risk, optimizing the carry trade can be a useful and productive way both to reduce risk and to add alpha. Indeed, it is an improvement on the differential forward strategy in so much as that is another expression of a basic carry trade strategy. The optimized carry trade strategy has consistently produced good returns with of necessity less volatility, resulting in higher Sharpe and information ratios.
It should of course be noted that just as one can optimize the carry trade for improved performance over the simple carry trade, so one can do exactly the same thing for either the differential forward strategy or the trend-following strategy. One does this by looking at volatility-adjusted exposure rather than the simple exposure per se. Thus, for example in the case of the differential forward strategy, one can over an extended period of time look at the relationship between implied volatility and historical volatility of the underlying exchange rate. Optimizing for volatility-adjusted exposure, the active currency manager would increase the leverage of the forward hedge when implied vol is below a predetermined threshold relative to historic vol at the same time as the forward points are in favour of the hedger, and conversely lower it when implied vol is above. The extent to which this generally improves performance far exceeds any concerns about increased transaction costs. One thing which may have to be taken into account however is the likelihood that raising or lowering the leverage of a differential forward strategy, both on an absolute basis and relative to the benchmark, may have an impact on the volatility of the tracking error.
Similarly, one can seek to optimize through volatility-adjusted exposure the trend-following strategy. Again, this should improve on the alpha provided by the basic strategy. A final point on these active currency strategies is that they are obviously not dependent on the base currency for adding alpha given that the total portfolio weighting and risk remains the same whatever the base currency.